European Banks
10 important questions on European Banks
Explain traditional banking business
What are important determinants of bank profitability?
- fee-earning activities. Off-balance sheet activities that include securitization of assets, credit lines, forwards, options.
Why do banks have a comparative advantage in providing liquidity?
- aggregate liquidity shocks are smoothed by the CB
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Banks serve as a delegated monitor. How do they monitor clients? What happens when the number of borrowers is large?
2. preventing opportunistic behavior of the borrower during the project (moral hazard)
3. auditing a borrower who fails to meet its contractual obligation (costly state verification)
When the number of borrowers is large, it is efficient to delegate monitoring to one party. A bank could delegate it to credit rating agencies.
What is the difference between direct and intermediate lending?
- firms that cannot issue direct debt on financial markets will request bank lending
- firms with low cashflow uncertainty borrow on the market, high uncertainty > bank lending
What is economic capital?
(worst case losses % - expected losses %)
! Large international banks strive to maintain an AA credit rating. AA means probability of default is 0.03%.
Explain Risk Adjusted Return On Capital (RAROC) and its shortcomings
revenues: spread between promised and risk-free rate
costs: % of loans
Within RAROC framework, banks first calculate risk for credit, market & operational risk & then aggregate the different risk types for the whole bank
shortcomings
1. focus on day to day risks, not tail risks
2. assumption that risks are independent & exogenous
What are the 3 different risk types?
market risk: risk of loss due to unfavourable movements in market prices, exchange rates, etcetera
operational risk: the risk of loss from inadequate or failed internal processes, people or systems
RAROC deals with risk that threaten solvency. But, banks also incur liquidity risks. How?
liquid resources can be managed by (1) maintaining a pool of liquid assets and by (2) preserving a diversified funding base
What is meant by cross-border penetration? And what are drivers of cross-border mergers?
concentration measures:1. market share of 5 biggest banks
2. Herfindahl index: sum of squares of the market shares of all banks
Up to 90's: belief that national financial institutions should not be controlled by foreigners. Prevented almost any cross-bordermerger. Recent mergers are more widely spread across EU.
Drivers for cross-border mergers
1. geopgraphic diversification
2. potential efficiency improvement
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